High Food Prices: An Investor's Dilemma

Droughts come and go but we may know in June how long the Renewable Fuels Standard (RFS) remains a blight upon the economic landscape. It has dramatically disrupted food prices and is the main culprit behind the current all time high price of beef that everyone’s talking about.

We will show in charts how dramatically this policy has affected agriculture commodity prices and the stocks of ethanol refiners and protein producers. Meanwhile, the rising cost of food drives some to decry inflation. Inflation is not to blame. Corn at $2.50 a bushel would deflate the food component of the CPI so fast that it would scare the Federal Reserve into enacting QE 4.

The following chart shows the extraordinary relationship between the RFS and crop prices. We’ll focus on corn because it’s so important to the food supply. The price of corn was stable - between $2.00 a bushel and $2.50 per bushel - for 50 years until George Bush signed the Energy Policy Act in 2005. That blew the first air into the food price bubble we see today.

When the Energy Independence and Security Act of 2007 passed, officially establishing subsidies and the ambitious, escalating mandate, prices marched to all time highs. As you can see, they took a breather for the “Great Recession” before racing, yet again, to fresh highs as the drought of 2012 hit. Again, droughts come and go, but when 40% of the supply is diverted away from food production…well, corn prices peaked that year at $8.25 per bushel, a nearly 400% increase above their long-term average.

As you can see in the chart, the Environmental Protection Agency (EPA) let some of the air back out of the bubble in August when it declared that it is considering reducing the mandate. Corn prices quickly took a 30% hit, so did soybeans. Keep in mind that this is merely a proposal; as yet hot air; they did not actually change anything.

All the EPA did was commence a “call for comment” period, a process they use to hear from various industries, consumer groups, and vested interests. This process invariably favors vested interests because, having more to gain, they have more to spend. With the administration making a new global warming pitch, it’s hard to imagine the EPA getting too aggressive cutting the mandate.

That skepticism is apparent in the market for Renewable Identification Number (RIN) credits, too, as you can see from the following chart (the red and blue lines represents D6 ethanol RIN and D4 biodiesel RIN prices respectively). RIN credits are like “get out of jail” cards for the refining industry. Refiners whocan’t meet the EPA’s blending mandate buy these credits from those whocan. A higher mandate leads to higher prices of RIN credits.

The ethanol RIN market saw a major correction after the EPA’s proposal to cut 2014 ethanol production numbers leaked out. But a doubling in price from 20 cents to 45 cents since November 2013 suggests that RIN traders may believe there is a chance that the EPA will reverse the proposed cut in its final rulemaking. Scott Irwin, chair of agricultural marketing at the University of Illinois, wrote: “The RIN market may be providing an early warning signal about a change in EPA policy”.

As it stands, the EPA is expected to address the policy again in late June. A reversal of their proposal might lead to some dramatic movement in commodity prices as well as the stocks of both ethanol and food producers.

Below, observe how the stocks of the major ethanol producers made decisive moves higher as their input costs in the form of corn prices collapsed post the EPA announcement.

In eight months, ethanol refiners
Green Plains Renewable Energy, a pure play ethanol refiner, rose 67%,
Valero Energy rose 52% and
Archer Daniels Midland rose 17%. Valero cite surging profits in their ethanol division, a growing part of their business, as a reason for their dramatic earnings outperformance. Their stock prices are tied to corn.

We’ve examined what we think is the cause of high corn prices. Now let’s look at the supply side response to those prices. The rising price of corn pulled other crop prices up with it. They also diffused through to beef and chicken prices.